Credit Risk Management

Is Credit Insurance Really Necessary?

The value of credit insurance is predicated on a credit insurers willingness to cover the risk that a company would otherwise not take.

Credit practitioners and finance executives have ignored this question for years. A nine-month discussion that began on LinkedIn last year reveals why the silence has been deafening.

Since the days of Adam Smith over two centuries ago, the extension of credit has served as one of the most important and enduring aspects of commerce. Yet, to this day, credit risk--a key component of credit extension--remains an enigma to many. Some fear it, some thrive on it, some avoid it, and some even go so far as to seek protection from it through something known as credit insurance.

Credit insurance is a product designed to protect creditors against various types of credit losses such as non-payment, insolvencies or catastrophes. Interestingly, it originated in Europe between the First and Second World Wars, not as a means of risk mitigation, but as a means of economic stimulus in the war-torn countries of Western Europe.

Although stimulus was the original intent of trade credit insurance, companies such as Euler Hermes, the world's largest, Atradrius and Coface--all based in Europe--have in the past 50 years moved far beyond the noble task of stimulating economies.

"Credit insurance clients use their policies not only to protect against catastrophic losses, but more as a way to maximize their ability to extend credit and improve the process, time and costs associated with vetting new customers," according to Greg McClintock who works in the Fort Worth, Texas office of Atradius, a $2.1 billion global credit insurer based in Amsterdam.

But is credit insurance really necessary?

Proponents, such as Raymond Ng, global credit manager at United Safety in Airdrie, Canada, claim they can't live without it. "Credit insurance is critical if you have a new export client with limited background information," Mr. Ng posted on a LinkedIn message board discussion that asked the question: Is credit insurance really necessary?

The discussion, which began on April 21, 2015, revealed for the first time both the pros and cons of an incessant, somewhat paradoxical product that has successfully weaved its way into the fabric of modern credit risk management.

Its users claim the product is invaluable in providing protection in high risk emerging markets, supplementing gaps or weaknesses within the credit department and, as one credit manager in the United Kingdom noted, "Credit insurance allows me to sleep at night." In fact, some companies in Europe and Canada use it to such an extent that, for them, the more appropriate question may be is the credit department necessary?

But skeptics of credit insurance say that the positives are outweighed by the overall costs, claim restrictions and coverage loopholes that sometimes result in outright termination of the policy when it's counted on the most. Furthermore, the critics say, credit insurance runs contrary to the basic principle of credit risk, thus removing any incentive for the company to manage and control its own exposure and market presence.

"I dont' think credit insurance serves any benefit to the business," said Mohannad Al Mofleh, regional credit manager at Al Tamimi & Company in Dubai and a former credit executive with BASF. "Most companies use credit insurance for two reasons: 1) psychological to feel that they have covered all the areas in risk mitigation, and 2) political to show management/shareholders that they are protecting their investment."

The Cost Paradox

Credit insurance, as with most basic forms of insurance, follows a premium-based business model that requires credit insurers to insure a certain number of healthy accounts in order to pay for the inevitable losses that come with risky ones.

In the accounts receivable world, such a model creates a cost paradox for both the insurer and the insured because in order to make a profit, credit insurers must limit coverage of the very accounts that companies want covered the most.

So credit insurers have cleverly circumvented that logic by marketing their product as a sales enhancer, thus positioning their costs as a cost of revenue rather than a cost of protection. After all, what company doesn't want to increase sales?

But, at the end of the day, costs are still costs regardless of where they appear on the general ledger and a closer examination of the costs associated with the sales-based credit insurance model, the most common, illustrates the true paradoxical nature of the product.

Using a basic example that arose on the LindedIn discussion, let's say that a company with $120 million in annual sales purchases a sales-based policy that insures the entire A/R portfolio at a rate of 20 basis points, as the cost of insurance is typically driven by interest rates, for an annual cost of $240,000.

The company has a days sales outstanding (DSO) of 55 days for an average monthly A/R of $18 million and a bad debt allowance (BDA) of 4.5%, which is high by most industry standards. Let's assume that one third of the allowance is written off (average write-offs range from 30-35% of allowances) for an eventual loss of $267,300. That would produce a gross savings of 11% before factoring in deductibles and coverage restrictions.

Another problem is that 20 basis points is an aggressive market rate even in a zero-interest rate environment and a company with a BDA of 4.5% will likely never receive such a rate. In a normal credit environment, such a rate would be suicidal for the insurer.

But look what happens if credit standards improve and the BDA decreases to 4.0%. The credit loss then drops from $267,300 to $237,600, costing the company even more money. A change in the bad debt allowance of only half a percent produces a cost/savings swing of 22%. Also, any rise or fall in sales would likely further the loss.

As Peter Hickey, the director of credit for Gulf Oil and a one-time credit insurance user said, "Over time, a credit insurer needs to collect enough in premiums to cover all the claims it pays plus make a profit so there are no free lunches with this or any insurance product."

Credit Protectionism

But as difficult as credit insurance may be to reconcile on the cost side, it's on the credit risk side where the necessity, and even the legitimacy, of the product comes into question.

Here again, however, the proponents of credit insurance remain undaunted. "I'm a big proponent of credit insurance," said Mike Frahlman, former corporate credit manager at Westlake Chemical Corp., a $4.4 billion company based in Houston. "It gives you a second set of eyes. They have no sales function putting pressure on them."

But skeptics who see the big picture say that using insurance to prevent credit losses is a form of protectionism that runs contrary to the free market principles from which the concept of credit risk derives its very existence. What use is credit risk if there is, supposedly at least, no probability of a loss?

Yet, that seems to be the view of many in Canada where credit insurance has a strong following. Youri Pinard, from Quebec, posted that when he interviews credit managers on topics such as letters of credit, guarantees, financial analysis, etc., the ones that use credit insurance say, "we actually don't bother...all our accounts are insured."

But Katie Keich, the director of credit and collections at Fusion Logistics, a Dallas-based firm, sees it differently. "If you have a strong credit team who lends smart, you don't need credit insurance," wrote Ms. Keich in a recent post. "We did an analysis going back five years measuring sales against our gross losses and, honestly, we didn't find one year where we could have saved by having credit insurance."

Off Target

Credit insurers and their allies claim that even the strongest credit departments are still not good enough to predict bankruptcies. Many cite the Target-Canada bankruptcy that occurred in January of last year, a bankrupcty that blind-sided many Canadian and even some U.S. suppliers, as a prime example of the need for credit protection.

But, here again, even with bankruptcies it seems there are no free lunches with credit insurance.

This has certainly been the case with a Canadian company that took one of the biggest losses in the Target-Canada bankruptcy, according to information provided to CreditPulse last year by the company's accounts receivable manager.

The company, in an all too common scenario, had essentially abdicated its credit risk function. The credit insurer, not the company, was responsible for performing vital credit functions such as credit investigation and setting credit limits.

But, the credit insurer apparently didn't see the Target-Canada bankruptcy coming either, which is astounding since Target Corporation is publicly-traded and the huge losses for its Canadian subsidiary were reported on the company's annual and quarterly filings.

As for protection, while the credit insurer did compensate the company for 90% of its loss at the time of the bankruptcy, the company will have to pay back to the credit insurer the amount not paid by Target as part of the bankruptcy claim, according to the A/R manager. It seems the credit insurer is doing little more than pushing paperwork, something the company could have easily and cost-effectively done on its own.

When asked about the costs, this A/R manager had a quick response, "Big time."